Friday, April 17, 2009

The capitalization of global equity markets is up over $7 trillion from the lows of early March, but it's still down almost $30 trillion from the highs of late 2007. Is a new bull market underway? I see lots of bears warning that this is merely a bear-market rally, that stocks have yet to hit their lows, and there is no shortage pundits warning that the economy is in dreadful shape and a recovery is virtually impossible without more wealth destruction on a global scale.

In my view, the origins of this latest rally can be found in a variety of indicators: sharply lower swap and credit spreads; higher commodity prices; rising shipping rates; quantitative easing by the world's central banks; lower implied volatility in stock and bond options; a steep yield curve; surprisingly strong profits at banks and brokerage firms; a surge in home resale activity; historically low mortgage rates; a relaxation of mark-to-market rules; a decision by the Obama administration to back off from its headlong dash to implement cap-and-trade and universal healthcare; and push-back from the Senate on Obama's request to cut deductions on charitable contributions, to name just a few.

Note that I did not cite bailouts or TARP or PPIP or massive government spending stimulus or trillion-dollar deficits. I think the economy was always capable of recovering by itself, given time and some help from the Fed to accommodate a surge in the demand for money. If anything, I think the stimulus bill passed earlier this year will only retard the economy's recovery, since it boils down to government grabbing a huge amount of the private sector's money and spending it inefficiently; that money could have been put to use in a far more effective fashion by the private sector if policies had been geared to increasing the incentives to take risk (e.g., by lowering income taxes, and/or reducing or eliminating the corporate income tax) rather than redistributing income and force-feeding infrastructure projects.

Maybe we will see another selloff or two before equity prices march significantly higher, but that's probably irrelevant. What seems to be happening now is the beginnings of a virtuous cycle. Our dynamic economy has had plenty of time to adjust to new and painful realities; prices have adjusted massively so that markets are now clearing; confidence is slowly recovering; wealth is returning; cooler heads are prevailing. It all feeds on itself, resulting in a classic "melt-up" scenario.

In coming months we are likely to see a slowing in the pace of layoffs and a bottoming in inventories. Hiring should then resume, and by that time the recovery will be obvious to everyone and the equity market will be significantly higher, even if the outlook for growth isn't all that great and trillion-dollar-deficit storm clouds darken the economic horizon. In the meantime, expect to hear a steady drumbeat of pessimism.